Income option credit spreads --- Adjustment of condor credit spreads
Consider for instance a 80/20 condor credit spread. If one were to put a spread on each and every time period (for instance monthly) for a large number of periods, the percentage of trades in which the stock price ends is at or above a short strike represents 20% of all trades. One of the techniques used consists in readjusting the spreads if the stock come close to a short strike, or the loss on the candor spread were to reach a given percentage of the premium received.
Let us refine a problematic trade, and trade in which the stock get dangerously close to the short strike. The question we post in this post is to estimate the percentage of such trades.
Let us consider the call side, and look at rules that trigger a readjustment when if the stock comes close to the short strike without crossing it. The number of bad trades (at expiry) is 10% (half of 20%). of all trades. The percentage of problematic trades must be greater than or equal to the percentage of trades that can reach the short strike. Let us then determine the percentage of of trades that reach the short strike.
To determine it we need to find an estimate of the probability that the stock will visit the short call strike, say strike 110 for a stoke trading at 100. We know that a trade that ends above 110 must have visited price 110 on its journey from 100 to a value above 110. We also know that among the visits that the stock will make to strike 110, approximately half of them (in fact it can be less than half) will end up above 110 at expiry.
Therefore the percentage of trades that will visit the short call strike is TWICE the percentage of trades that will end at a price higher than the short call strike. In the case of the 80/20, even if there is only a 10% change that a trade will end up above the short call strike at expiry, at least 20% of the trades will become problematic for the call side.
A similar reasoning can be made for the put side.
Therefore the percentage of trades that will problematic (need readjustments) is more than the double of the trades that have been legitimate adjustments. In other words, among all the adjustment made more than half of them would have been not needed, and these trades would have been winners.
This is significant because it means that the winner that will need no intervention in an 80/20 condor is actually less than 60% of the trades (probably around 50% or less) depending one where one make the adjustments.
A number of websites and people assume that they would make adjustment 20% of the time, and do nothing during 80% of the time, when in fact it is not true.
In an 80/20 condor one should expect to be busy with adjustment at least almost once in every other trade.
Saturday, September 25, 2010
If You Have Two 5 Years Condor Spread Trading Records From Two Advisory Services, Could One Of Them be Reliable?
If You Have Two 5 Years Condor Spread Trading Records Each, Could One Of Them be Reliable? You guessed it right: the answer is the classical expression "It depends". Let us check what it depends on, and how to make a determination.
In the previous post, we explained why a minimum of 10 years are needed to make a judgment on an 80/20 condor spreads trading record. Suppose that when you visit the web, you find a number of advisory services that provide five year record. Could some of these trading records be useful? It depends on the probs assumed in the spread, and the duration of the spread, which we shall assume is 1 month.
We mentioned the expression of a "bad trade", but we did not define it. For the purpose of this analysis at least, a bad trade where the stock price is at or above the short strike at expiration. Please make sure you do not confuse this definition, with another definition that may be in your mind such as a trade in which the stock reaches a short strike during the life of the trade, which is probably the one you may have in mind, or an even worse definition of a bad trade. The latter definitions of a bad trade lead to larger percentage of bad trades than implied in the numbers attached to the condor spread. In the next post, we are going to address this issue in more depth. So do not go away as they say on CNN-- we will be right back.
Now we are back to our analysis. If we take the 80/20 condor spread, a bad trade (for the purposes of this post) is a trade that finishes at or above a short strike. There are 20% of them on average, and we explained in the previous post why one needs 10 years. Let us call a advisory service that offer these spreads as advisory A. 5 years in not enough for advisory A. Let us say a second advisory, denoted advisory B, follows (more aggressive spreads) 60/40 monthly condor spreads . In this case, a 5 year period would generate 24 bad trades for advisory B, and therefore the 5 years meet the minimum requirement for advisory B, but not for advisory A.
The lesson: A smart condor spread trader should then ask not only for the duration of a spread, and the length of the trading record, but should also ask about the nature of the spread, and make sure that it was kept consistent---For instance, you do not want to have in the same record 80/20 spreads in certain months, and 60/40 in another months, etc. You then use the rules as discussed above.
While asking your questions to the advisory guys, if the guys do not seem to understand what you are asking for and why you asking for the information, then you have an indication about the intellectual strength of the intellectual strength of the advisory service---Edges can take a conceptual form.
Before I leave you, I have a question: Could we have a 50/50 condor spread ? If yes, could you apply the analysis above?
Answers: I will wait before I give it to allow you time to think about it. Make sure you visit in a few days. It will be here. You can also post your answer in the comments section below.
In the previous post, we explained why a minimum of 10 years are needed to make a judgment on an 80/20 condor spreads trading record. Suppose that when you visit the web, you find a number of advisory services that provide five year record. Could some of these trading records be useful? It depends on the probs assumed in the spread, and the duration of the spread, which we shall assume is 1 month.
We mentioned the expression of a "bad trade", but we did not define it. For the purpose of this analysis at least, a bad trade where the stock price is at or above the short strike at expiration. Please make sure you do not confuse this definition, with another definition that may be in your mind such as a trade in which the stock reaches a short strike during the life of the trade, which is probably the one you may have in mind, or an even worse definition of a bad trade. The latter definitions of a bad trade lead to larger percentage of bad trades than implied in the numbers attached to the condor spread. In the next post, we are going to address this issue in more depth. So do not go away as they say on CNN-- we will be right back.
Now we are back to our analysis. If we take the 80/20 condor spread, a bad trade (for the purposes of this post) is a trade that finishes at or above a short strike. There are 20% of them on average, and we explained in the previous post why one needs 10 years. Let us call a advisory service that offer these spreads as advisory A. 5 years in not enough for advisory A. Let us say a second advisory, denoted advisory B, follows (more aggressive spreads) 60/40 monthly condor spreads . In this case, a 5 year period would generate 24 bad trades for advisory B, and therefore the 5 years meet the minimum requirement for advisory B, but not for advisory A.
The lesson: A smart condor spread trader should then ask not only for the duration of a spread, and the length of the trading record, but should also ask about the nature of the spread, and make sure that it was kept consistent---For instance, you do not want to have in the same record 80/20 spreads in certain months, and 60/40 in another months, etc. You then use the rules as discussed above.
While asking your questions to the advisory guys, if the guys do not seem to understand what you are asking for and why you asking for the information, then you have an indication about the intellectual strength of the intellectual strength of the advisory service---Edges can take a conceptual form.
Before I leave you, I have a question: Could we have a 50/50 condor spread ? If yes, could you apply the analysis above?
Answers: I will wait before I give it to allow you time to think about it. Make sure you visit in a few days. It will be here. You can also post your answer in the comments section below.
Option Condor Spread Writers -- How Long Should A Trading Record Be?
Short answer: a reliable track record needs at least 10 years! We explain why below, but first some introductory remarks.
One should not confuse a high probability trading strategy with a trading strategy that has an edge. A well known example of high probability strategies is the option condor strategy, in which one sells one put and one call, and hedge them by buying a put and a call that are respectively at higher and lower strikes, when compared to strikes of the call and the put that were sold. This leads to "impressive" annualized yields because of lower margin requirements (which are the difference between strikes adjusted by the net premium), and condors can be designed to achieve a high probability of success in one trade.
For instance, it is not unusual to write these condor spreads so that the probability of the stock ending between the two sold strikes is 80% (with a yield on margin that impresses the eye). When option beginners look at these numbers they are typically impressed, and .do not think in sufficient depth about the risks.
The typical condor writer makes a series of successful trades, and then one day a non successful trade can come along, and wipes all profits. It may even lead to the loss of the whole capital, if all of it was used as margin, and the bad trade involves gap well beyond the long protective strikes.
One can find a number of option advisory services that provide condor spread signals. People can be easily impressed by the numbers. An advisory service typically posts a track record, and they in different length, from 6 months to 6 years/etc.
What is an acceptable track record in terms of length of time, and why?
This is a core issue with all trading strategies with high prob of success on one trade. If the prob of success is say 80% on one trade, it would mean that one would need 10 years to generate 24 trades that are bad. A sample size of around 25 is needed to form a scientific conclusion, via the application of the Central Limit Theorem/Law of "large numbers".
Therefore a reliable track record needs at least 10 years!
Interestingly, some of the well known times when option writers took major hits were separated by 10 years: crash of '87, crisis of '98, and the credit crunch crisis ten years later.
There is an alternative to track records based on observed numbers and time: one needs to prove theoretically (using mathematics) that a high prob strategy has a positive edge.
One should not confuse a high probability trading strategy with a trading strategy that has an edge. A well known example of high probability strategies is the option condor strategy, in which one sells one put and one call, and hedge them by buying a put and a call that are respectively at higher and lower strikes, when compared to strikes of the call and the put that were sold. This leads to "impressive" annualized yields because of lower margin requirements (which are the difference between strikes adjusted by the net premium), and condors can be designed to achieve a high probability of success in one trade.
For instance, it is not unusual to write these condor spreads so that the probability of the stock ending between the two sold strikes is 80% (with a yield on margin that impresses the eye). When option beginners look at these numbers they are typically impressed, and .do not think in sufficient depth about the risks.
The typical condor writer makes a series of successful trades, and then one day a non successful trade can come along, and wipes all profits. It may even lead to the loss of the whole capital, if all of it was used as margin, and the bad trade involves gap well beyond the long protective strikes.
One can find a number of option advisory services that provide condor spread signals. People can be easily impressed by the numbers. An advisory service typically posts a track record, and they in different length, from 6 months to 6 years/etc.
What is an acceptable track record in terms of length of time, and why?
This is a core issue with all trading strategies with high prob of success on one trade. If the prob of success is say 80% on one trade, it would mean that one would need 10 years to generate 24 trades that are bad. A sample size of around 25 is needed to form a scientific conclusion, via the application of the Central Limit Theorem/Law of "large numbers".
Therefore a reliable track record needs at least 10 years!
Interestingly, some of the well known times when option writers took major hits were separated by 10 years: crash of '87, crisis of '98, and the credit crunch crisis ten years later.
There is an alternative to track records based on observed numbers and time: one needs to prove theoretically (using mathematics) that a high prob strategy has a positive edge.
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